The ABC of Economies of Scale

 

Pexels Image by David McBee

Heard about economies of scale? Well, no problem if you haven't. This article from The Everyday Entrepreneurs Blog will take you through what it is, how to achieve it, and what the pros and cons are. Have a wonderful read. 

Economies of Scale Definition

Economies of scale refer to the economic or cost benefits that result from successful business scaling. The term is unequivocally hinged on scaling and luckily, we thoroughly grilled the topic of scaling in this article. You should jump on it and return later - if you are yet to do so. 

Now to the subject before us. 

An economy of scale is established when a business increases its output and does so efficiently without expending more cost. 

How to Achieve Economies of Scale

Specialization:

Specialization is a key component for achieving an economy of scale. It involves focusing on producing a specific good or service. By choosing a small range of products, businesses can quickly learn all they need to and become experts in developing such. 

Let's say, for example, that there are two companies of the same size and capacity. Company A produces bags and shoes while Company B specializes solely in bags. 

The effort of employees within the first company is divided to cover both bags and shoe production. They manage clients from both markets, conduct various market and technical research, and have complex accounting to handle (calculating tax for both products), to mention a few.

Company B, on the other hand, have fewer distractions. All employees focus on is bag production. The accounting is much smoother, the team thinks in one direction, and there's room to learn fast, increase production, and serve customers effectively.

Bulk Inputs:

Companies that are able to make bulk purchases often access economies of scale earlier than others. This is as a result of cost-saving, realised when buying large amounts of raw materials, tech, or equipment at a discounted price. 

Comparing this saved cost to the profit from sales of finished products, it becomes clear how much productivity has been achieved. 

Smaller companies find it difficult to achieve such results since they do not have the capacity to make large inputs. 

Risk Diversification:

A key component of economies of scale is resilience. And how does a business build resilience? Through risk diversification. 

Risk diversification bascially involves creating different channels of income, maintaining a large customer base, entering new markets, and positioning for relevant infrastructural development. By implementing these, the business in question will create a higher chance of positive returns, reduce single-point of vulnerability, and maintain overall flexibility. 

Improved Processes:

Every company that achieves an economy of scale has considered improving its physical processes. There are three major considerations here. One is how to reduce working time. The second is how to retain quality or even improve it - despite reduced work time. And the third is how to cut costs while staying on track with the first two. 

Achieving one or more of these three objectives will improve your processes. 

We must mention that there is another side to this. It involves improving processes that do not relate to physical business activities. For instance, brainstorming about other economy-of-scale factors such as, which products to specialize in, how to ensure bulk input, or how to acquire cheaper loans. 

It is important to consider what trade-offs you may be making when you begin realising an improved process. 

Cheaper Loans:

Cheap loans are loans that bear low interest rates. With such low interest, businesses will spend less on repayment. 

This is crucial for attaining an economy-of-scale. The reason is that these cheap loans provide a means for scaling, with little or no financial implications. Unfortunately, many loan-seeking businesses are extorted by credit grantors.  

They are given unfavourable terms such as high interests, short loan durations, or strict penalties for payment defaults. Such conditions put the business under pressure to balance repayments with the cost of running production. 

Spread Fixed Costs:

Fixed costs are costs that remain constant for a certain range of production. For example, let's say you pay your workers per hour. Such an arrangement clearly covers the time spent on the job rather than the work done.

Now, imagine that your employees have been delivering/assembling one product hourly for ages. Suddenly, a new employee delivers two full products within the same timeframe - using the same tools. The employee may have to put in more effort and manage distractions to achieve this. Nevertheless, they ramp up your production for the same cost. 

It shows that you can double your business output while maintaining the same salary expense. This is precisely how fixed costs are realized. 

Spreading fixed costs then implies allocating fixed costs across the units of output. Generally, this is a fundamental aspect of cost accounting and financial management for businesses. It enables usinesses  make informed decisions about pricing, production levels, and profitability.

Did You Know? Economies of Scale can lead to monopolies or oligopolies within an industry. This could significantly narrow customer choices or restrict smaller firms from growing. 

Internal vs External Economies of Scale

There are two types of economies of scale. One is internal and the other is external. We take a close look at each of them in this section. 

Internal Economies of Scale

Most of the time when we talk about economies of scale, we're referring to the internal economies of scale. 

The first thing to know about internal economies of scale is that they are unique to a business. With its peculiarities, your company will have to make very distinct changes. Reshuffle supervisors, find better ways of collecting feedback, adjust workload or schedules - you name it. 

This will not be copiable by other companies even if you were to share them. However, the result must be positive towards managing costs and ramping up production. 

External Economies of Scale

External economies of scale occur through external processes. They impact entire companies and are relevant within a specific industry.  

Internal business decisions and activities do not have a direct impact here. However, they can still produce substantial results. 

For instance, a business may forecast certain infrastructural developments in a specific region and plant itself there. The development could happen through government intervention, such as a road construction project. Nevertheless, the business will stand to benefit from it.  

Advantages of Economies of Scale 

Increased Business Competitiveness

Through economies of scale, businesses get to cut or lower their expenses. Reduced production costs then leads to lowered price of goods and services. Businesses that implements this automatically become more attractive to customers, clients, and investors. 

Their new found popularity takes them up the ladder of competition.

Increased Profit

The most obvious result of economies of scale is a significant increase in output. For the average business, this means more sales and increased profit.

Potential to Grow Further

Profit realised from an economies of scale can be used in many ways. One of such is reinvesting in the business itself.  

Startup founders may rapidly grow their business after the first scaling. They do this by following a very straightforward sequence. Profit, Reinvest in the business, Achieve more economies of scale, and Profit. 

Better Salaries and Stakeholder Benefits

Employee salaries will likely increase when the company assumes more profitability. After all, some of that money should be used to appreciate the people who are making things possible, right? 

In addition to this, stakeholders will realise one form of benefit or the other. 

Disadvantages of Economies of Scale

While there are advantages, economies of scale also has some draw backs. 

Low Employee Morale 

As a company scales. it becomes larger and employees may feel more and more dissociated. Remote work tends to promote such feeling among different individuals. This could have negative impact on their enthusiasm and overall productivity. 

Increased Regulation

Governments and regulatory bodies keep a close eye on small companies rapidly experiencing growth.  The authorities try to ensure that such companies remain within regulatory boundaries as they change phases, roles, or activities. 

But close monitoring and regulatory follow up is exhausting for businesses. In some cases, it eats into their time and resources. 

Threat from Competitiors

Competitors might try to push a business out of the market once it begins to scale. As a small and minor competitor, you may be left untroubled. However, trying to acquire more market share will most likely put you in the crosshairs of industry giants. 

And who knows what your competitors will choose for an offensive? An adverisement. A lawsuit. It could be anything. 

 

Did You Know? Economies of Scale is thought to have been fomarlised by Adam Smith through his 1776 publication titled "The Wealth of Nations".